Commentary on how China and the world are adapting to each other -- or not.

July 25, 2011

Credit Rating Pitfalls Difficult to Escape

For eons foreign countries have complained bitterly about the power of Moody's, S&P, and Fitch to hurt their economies by downgrading their ratings. Japan, Brazil, Greece, and many others have stories to tell of heartache and suffering. Even China has only gradually come to terms with these powerbrokers, in part because the rating agencies have given relatively strong ratings to the PRC. There has been criticism in the US of the ratings agencies, but not because of low ratings, but because of overly high ratings over the years: Orange County in the 1990's and of collateralized debt obligations (CDO's) of subprime mortages that precipitated the 2008-09 financial crisis.

Get ready for a change. If the US goes into the default on its debt obligations and does not present a credible plan for reducing its debt over the long term, the Big Three will downgrade the US. According to Jonathan Capehart, that'll likely lead to a 100-basis points increase in US interest rates and a one-percentage point drop in GDP growth. That's a job-killer for sure. The rating agencies will come in for some serious, sustained criticism if this is the result.

However, this whining will unlikely lead to serious penalties for the rating agencies, and it's likely they'll continue to hold the US and other economies hostage. Why? Not because they're so smart and deserve this power, but because dozens upon dozens of US laws have integrated ratings into their regulatory frameworks. Rating agencies are quasi-regulators of both issuers and investors. It would take a mountain of effort by Congress, state legislators, and executive branch agencies to unwind rating agencies' regulatory powers. Even more, rating agencies' views are essentially protected from scrutiny because the Supreme Court has ruled that their ratings are "free speech" and immune from prosecution except if it can be shown they intentionally erred.

In short, the US government is ensnared in a web of its own making. What should be done? Well, perhaps not much. I think it's nuts that rating agencies' ratings are seen as simply "speech" when their ratings have obvious economic consequences in ways that go beyond standard talk. If every word you said move markets -- by law -- you ought not to be seen as just tooting a horn. We also can introduce more competition into the ratings business, which has already started. But other reforms, such as outlawing rating agencies from collecting income from issuers, present a host of problems. In short, I see no quick fix, only troubles ahead.